The US estate tax trap for Israeli investors

Israelis buying real estate in the US may not be aware of their exposure.

Since 2008, Israelis have been investing in US real estate in record numbers. While the US income tax implications of such investments are well known, there is another, potentially painful, tax that Israelis (and other foreign investors in the US) are ignoring - the US estate tax.

Most US citizens do not pay estate tax. That’s because (i) assets transferred to a surviving spouse are not taxed, and (ii) there is an $11.2 million dollar exemption for assets transferred to other persons. However, in the case of non-citizens, transfers to a spouse are taxed, and the exemption amount is only $60,000.

Just to illustrate this discrepancy:

Let’s take two brothers, Aharon and Baruch, both of whom are Israeli citizens and reside in Tel Aviv. Aharon had lived in the US and became a US citizen decades ago. A relative dies and leaves Aharon his $5 million Park Avenue (New York City) apartment. Baruch inherits a $5 million beach house in the Florida Keys.

Years later both brothers pass away. Assuming Aharon (the US citizen) had less than $11.2 million in total assets (including the inherited, Park Avenue apartment) at the time he died, no US estate tax would be owed. Conversely, Baruch’s estate (assuming that he had no other US assets) will have to pay the US Treasury more than $1.8 million.

Let’s explain that result. Non-citizen, non-residents of the US are taxed on the value of their US assets at the time of their death. US assets include:

US real estate;

stock in a US corporation;

debt obligations of a US person (with exceptions for certain bank deposits and “portfolio interests”);

interests in US partnerships; and

interests in US trusts.

US estate tax rates start at 26% and increase to a maximum rate of 40% at the $1 million mark.

In our case, Baruch owned US real estate worth $5 million. If he had a brokerage account and held US stocks, like Google, Facebook or Boeing, those would also be taxed, even if that brokerage account was with an Israeli bank or brokerage firm.

So, we see that Baruch ends up paying close to 40% of the value of his estate in taxes.

By the way, if Baruch was inherited by his wife (also not a US citizen) and she died a year later, her estate would have to pay the approximately $1.8 to the US Treasury again.

Let’s explore an example closer to the average reader’s situation: Yosef Cohen, an Israeli citizen who lives in Israel, invests $200,000 in US real estate (even if held in a fund). When Yosef dies, his estate could owe the US government $42,000 ($200k- $60k = $140k times 30%). That’s 21% of the initial investment!

Here’s the good news….

Like with income tax where the best professionals can lower or defer the tax burden, professional estate tax planning can similarly reduce, and perhaps even eliminate, your burden entirely. That’s not to say it is easy to wipe out the estate tax, but there are ways to turn it from a major exposure to an almost painless bother.

These steps involve using non-US corporations and trusts. Note, however, that the income tax implications of using these entities must also be considered.

There are three main reasons that Israelis neglect to provide themselves with an effective US estate tax plan:

1.Many people naturally feel uncomfortable in thinking of their own death. Since no one knows when they’ll die, we have no natural stage at which to contemplate the tax on our assets when we die.

Americans know that as April rolls around each year they must file income tax returns. Estate tax is not as accommodating. This applies to all people, not just Israelis.

2. Since there is no Israeli death tax, many Israeli investors in US assets fail to take notice that there is a US estate tax.

3. For some reason, people think that their death will go unnoticed by the IRS and if the IRS does notice they won’t pursue you to Israel (I have heard this from more than one potential client).

Let’s deal with Reason 3. While it’s true that the IRS will not necessarily be notified when an Israeli has died (they aren’t necessarily notified when a US person dies, either), there are a few ways that the IRS could find out:

1. If you’ve been filing US tax returns, your heirs or executor will still have to file a return in the year you’ve died.

As an attorney, I can’t say how much one should avoid this approach, but I’ve heard the strategy to avoid US estate tax is to show that you disposed of your US real estate right before you died. Of course, this will only work if you hold your US assets in an LLC or other vehicle and your heirs and the LLC managers are willing to commit fraud on your behalf…and the IRS accepts the facts as they fraudulently describe them. Note, this may trigger some unpleasant income tax consequences for you and your heirs and you may lose out on some excellent income benefits for your heirs.

In reality, I don’t believe anyone has really thought this through and done the right analysis. While I can see a person foolhardily relying on his own ability to defraud, I can’t imagine one could honestly think that his heirs, right after his death, would have the knowledge and the prescience to pull this off.

2. If you own real estate directly, when your heirs try to transfer the deed they may be asked to show proof of a filed estate tax return.

3. If your US stocks are held in an account at a bank (even an Israeli bank), don’t be surprised if the bank insists upon proof of an estate tax return before transferring the name on the account. We learned from FATCA that the Israeli banks will give your information to the IRS.

So, plan ahead and give your assets to your heirs, not to the US government.

Adv. Avrum Aaron, Esq. has been a US attorney for 24 years and an Israeli advocate for 16 years. He is the principal of Avrum Aaron & Associates, a US law firm, and a partner in the Tel Aviv Tax Advisory firm of Ettinger, Eichler & Aaron.